Recent events in the crypto market have brought up conversations about the importance of self-custody for users. According to CNN, major crypto exchange FTX declared bankruptcy, and at least $1 billion worth of users' cryptocurrency has gone missing. Before this, crypto lender Celsius also went bankrupt, losing over $4 billion worth of its user's funds, according to CNBC.
While centralized exchanges may be convenient for users to store their crypto holdings if anything were to happen to the exchange, there's no guarantee that anyone can get their funds back. This is why it is often recommended for users to store their crypto using a wallet that gives them access to the seed phrase and private key. Centralized exchanges control the private keys for a user's funds, so when they go down or get hacked, there is no way for a user to retrieve their funds.
For example, suppose someone downloaded a self-custodial wallet app, and it stopped working. In that case, the user can use the seed phrase to import their wallet into another wallet application and retrieve their funds. With centralized exchanges, this is not possible.
How crypto wallets work
To better understand this, let's look at how crypto wallets work. Crypto wallets signify the ownership of blockchain-based assets, including cryptocurrency and non-fungible tokens (NFTs). Wallets consist of a public key and a private key.
The public key allows anyone to receive transactions from another user. Public keys appear as a long string of numbers and letters and act as a destination address for incoming transfers. It's similar to how bank accounts have a sort code and account number that enables users to deposit money into the account. However, similar to the sort code and account number found in bank accounts, the public key cannot be used to spend funds from a crypto wallet; this is where the private key comes in.
The private key allows users to spend funds from their crypto wallets. They're similar to a card number, expiry date, and security code found on credit cards. If anyone gets access to a person's private key, they can also spend all of the contents of the wallet.
The wallet address is another way that users can receive crypto in their wallets and, in many cases, is a hashed (shortened) version of the wallet's public key. Since addresses are shorter, they are more convenient to use when receiving crypto. Users can also generate wallet addresses multiple times depending on their wallet app. This is because, as mentioned earlier, the address is simply a hashed version of the public key.
Finally, a seed phrase is a group of random words that are generated each time a new wallet is created via a wallet application. You can think of this as the proof of address and identification a bank asks you for when you call them up or visit them in a branch to prove ownership of your bank account. Therefore, users must keep a copy of their seed phrase offline and in a safe place (i.e., a piece of paper or a computer with no internet access and very few apps).
The seed phrase is used as a backup for the wallet in case the wallet app stops working, a user loses the device containing the wallet, or any event that causes them to lose access to their wallet. In addition, users can recover their funds by importing their wallet into another app by entering the generated seed phrase.
Solutions
The best solution is for crypto investors to download and use non-custodial crypto wallets, keep their seed phrases safe, and not store large amounts of tokens on an exchange. Using centralized exchanges may be more convenient, but safety trumps convenience regarding large amounts of cryptocurrency.
Centralized exchanges should only be used for trading and converting cryptocurrencies into fiat currency, with a personal wallet acting as a personal bank account.
Conclusion
While self-custody has always been an important practice for crypto investors, the benefits of it have become more apparent due to recent events. Crypto holdings are more secure when the user has access to the private keys and seed phrases, so their funds can be recovered anytime.